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January 24, 2014

Which Funds Will Outperform? Active Share Benchmarking May Offer Clue

Research shows that portfolios that vary significantly from their indexes tend to outperform them over time

The search for performance never stops, and any tool or metric that offers a reasonable chance at generating alpha is worth considering.

Active share, a fairly new metric for analyzing mutual funds’ portfolios, has received a good deal of attention lately. Although some researchers are skeptical about the measure’s value, others believe it provides useful information for investors.

Active share calculates how a fund’s holdings compare to the positions in its benchmark index; its value is measured on a scale from zero to 100%.

A low share value indicates that a fund is closely tracking its index. For example, an S&P 500 Index fund would have a value very close to or equal to zero. That makes sense: It’s a passively managed fund designed to track the index as closely as possible, so there’s little or no deviation in holdings.

In contrast, a fund with a high active share of 80%, for instance, is considered actively managed, because its holdings will differ significantly from the index.

The scale for measuring active share uses the following ranges, according to Touchstone Investments:

Active share range

Interpretation

0%-20%

Passive

20%-60%

Closet index

60%-100%

Active

Background

The active share measure started drawing attention in several years ago.

A study by finance experts Antti Petajisto and Martijn Cremers, for instance, analyzed fund performances from 1990 to 2003. They concluded that high active share funds outperformed their benchmarks before and after fees, that active share was persistent, and that it is an indicator of future alpha.

Another key finding that won’t surprise advisors is that closet indexers underperform benchmarks, after fees and transaction costs. Again, that makes sense: Passive low-cost index funds will have an advantage over managed closet index funds that incur higher costs.

Subsequent research has both supported and challenged the original findings on the value of active share.

Vanguard researchers Todd Schlanger, Chris Phillips and Karin LaBarge published, “The Search for Outperformance: Evaluating ‘Active Share' ” in 2012. Their study of more than 900 funds covered an evaluation period from 2001 through 2005; the performance period tracked the funds from 2006 through 2011.

Their key findings differed from prior results:

Higher levels of active share did not predict outperformance.

Contrary to conventional wisdom, “high-conviction funds” with high active share did not significantly outperform low-active-share funds.

The higher the active-share level, the larger the dispersion of excess returns.

The higher the active-share level, the higher the fund costs.

Funds with the highest level of active share tended to be concentrated in mid- and small-capitalization equities.

Investors’ Perspective

Touchstone Investments of Cincinnati, Ohio, relies on subadvisors to manage the firm’s mutual funds, and these funds tend to hold concentrated portfolios — i.e., they are “high-conviction” managers — that typically have 30 to 35 holdings, according to President Steve Graziano.

The funds also have high active shares, which Graziano describes as a by-product of the firm’s manager selection criteria. In his view, the data on the importance of high conviction and active share are solid.

“Those high-conviction managers, both in the study from 1980 to 2003 and the updated study from ’08 and ’09, confirmed that those funds that are in the upper quintile of active share significantly outperformed by over 100 basis points all of the funds,” he said in an interview with ThinkAdvisor. “So, I think that’s unassailable.”

Active share is only one measure that Touchstone Investments uses to evaluate potential subadvisors.

In a July 2013 white paper on active shares and manager conviction, the firm notes that it views these metrics “not as a harbinger of definite outperformance, but as indicators that a strategy has the opportunity to outperform. In such context, active share can be a valuable element of investment manager evaluation and fund analysis.”

Vanguard’s report comes to a similar conclusion about using active share as one more tool in the search for alpha: “However, combined with careful qualitative judgment regarding the health of the investment manager’s firm and the depth of its analytical team, active share can be a useful addition to the investor’s toolkit of portfolio evaluation measures,” the fund shop explained.

“Although moderately correlated with other measures of active management, the relationship is not perfect,” Vanguard experts wrote. “Thus, active share adds another unique dimension. It is equally helpful in comparing the appropriateness of different benchmarks and in monitoring the consistency in a portfolio’s investment strategy over time.”

(To learn more about active share and research about the metric, see a synopsis put together by Deborah Kidd, CFA.)

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